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This Week in FX: Watch for USD Shifts
03/19/2012 9:40 am EST
Changing correlations between the dollar and risk assets are now taking effect, and the announcement of the UK’s new budget this week will also weigh on world currency markets.
This past week, US Treasury yields broke out of their ranges and rocketed higher. Ten-year yields rose nearly 28 basis points (bps) since Monday and advanced above the 200-day simple moving average (SMA) for the first time since July to reach current levels of around 2.31%.
US equity markets rallied significantly as well this past week with the S&P 500 closing above 1400 for the first time since 2008, while the Dow Jones Industrial Average traded at levels that have not been seen since 2007.
At the same time, the US dollar (USD) gained against its major counterparts, most notably against the Japanese yen (JPY). This may be the start of a significant shift in FX drivers, as a risk rally has typically coincided with USD weakness and a selloff in US Treasuries (yields higher).
What we are seeing now is that the USD and its relationship to the risk-on/risk-off environment is deteriorating as markets revert back to fundamental drivers and interest rate differentials. The correlation between the dollar index and the S&P 500 has diminished with the 30-day rolling correlation (based on percentage change) now at -0.42 from -0.59 late last week. This underscores the breakdown in the inverse relationship between risk and the greenback.
On a shorter-term basis (five days), the correlation has actually turned positive for the first time since July of last year, which indicates a positive relationship between the USD and risk (i.e. risk-on, dollar strength).
US economic data and what it implies for Fed policy moving forward is increasingly impacting exchange rate fluctuations while risk sentiment has taken a backseat. Positive data surprises have been constructive for the greenback as traders price out the likelihood of QE3 while the economy improves. Likewise, softer data weighs on the buck, as seen with Friday’s weak February industrial production, softer core CPI, and unexpected decline in consumer confidence.
While the Fed has not completely taken the option of more asset purchases off the table, it has backed off from the prospect of additional stimulus for now and acknowledged positive developments in labor markets and expects “moderate” (upgraded from “modest”) economic growth.
The pledge to keep rates low until late 2014 remains unchanged, however, if more members join Lacker in his dissent with regards to the time commitment, yields could move higher and the dollar may follow suit. The week ahead sees a number of Fed speakers scheduled, which include FOMC voting members Dudley, Lockhart, and Chairman Bernanke.
There is relatively light data flow in the US with key February housing reports (new and existing home sales, housing starts) and leading indicators of note. We will also be monitoring weekly jobless claims, which hit multi-year lows of 351,000.
We expect that the USD will continue to be the beneficiary of safe-haven flows as the Swiss franc (CHF) and JPY are expected to remain weak as a result of Swiss National Bank (SNB) and Bank of Japan (BOJ) policy stance.
This past week, the Swiss National Bank reiterated its commitment to maintain a ceiling on the franc, while the Bank of Japan seeks to achieve its 1% inflation target, which may require further easing of monetary policy as Japan currently faces deflation. The removal of a significant tail risk in Europe and easing of financial conditions after extraordinary liquidity operations provided by the European Central Bank (ECB) have resulted in a rise in European bourses and reduction in sovereign yield spreads.
We would not downplay the severity of the Eurozone crisis, however, as the situation remains fragile. Political disruptions may intensify heading into key elections, and structural imbalances as well as a pending recession continue to be a major concern. Eurozone PMI’s are scheduled for release in the week ahead, and this will provide insight into the economic growth of key nations in the region.
Budget D-Day in the UK
The highlight event in the UK this week is the Chancellor of the Exchequer, George Osborne, presenting his budget to Parliament on Wednesday, March 21 at 1230 GMT. This comes at a difficult time for the exchequer, as growth faltered in the fourth quarter of last year, and although it is expected to recover later this year, it is likely to remain fairly lackluster this year and next.
However, as much as the Chancellor may want to try and boost growth, he needs to balance this with preserving the UK’s prized AAA credit rating. Thus, don’t expect a deviation from the government’s austerity program, as it has become even more pressing since rating agency Fitch joined Moody’s and put the UK on ratings watch negative last week.
Osborne could have some good news on this front. There are signs the UK’s finances are better than expected. The Office for Budget Responsibility’s borrowing estimate for 2011-2012 was GBP127 billion, however, the actual figure is likely to come in below this at the GBP122 billion mark after tax receipts were extremely strong in January and public spending has been slower than anticipated.
The UK still has a mountain to climb when it comes to fiscal consolidation, so don’t expect any un-funded giveaways from Osborne this year. Instead, we expect a few changes that may cause some volatility in sterling-based markets in the middle of this week.
The markets are likely to react positively to anything that is pro-business, for obvious reasons. But this budget could be more muted than usual since a corporation tax cut is due to come into effect in April 2012 as part of the Finance Bill.Â We don’t believe the Chancellor will cut the new 25% rate any further this year, although a small cut like 1% could surprise the market and might be considered affordable by the Chancellor, especially if it could help boost jobs in the UK economy.
Any reduction in red tape for business is also likely to be warmly welcomed by the markets, including the outcome of the Office for Tax Simplification’s review of the taxation program for small businesses and a reduction in the compliance burden for firms with foreign subsidiaries.
Added to that, any cut to the top 50% rate of tax, which could be reduced to 45% and maybe even back to its original 40%, may not be popular with the overall electorate, but could help boost consumption among high earners. The Chancellor may admit that the tax increase for those earning GBP150K or more failed to bring in the GBP 2 billion revenue expected, so it is not worth keeping in place.
We believe a pro-business budget could have a temporary upward impact on the pound only. However, a budget that either 1) constrains growth, or 2) threatens the UK credit rating could have a longer-term negative impact on sterling.
The pound had a storming end to last week’s trading session, as the dollar gave back recent gains. It closed the week on Friday approaching its 200-day SMA resistance at 1.5870. This could thwart further gains as we start the week as markets get nervous about the prospect of Osborne’s budget and take profits.
We also get Monetary Policy Committee (MPC) minutes and inflation out this week. Any sign that inflation is not falling as fast as the MPC predicts could see expectations of QE get taken off the table. This could limit future declines in the pound, especially versus the euro, the CHF, the yen, and the dollar. These currency crosses are all being driven by relative monetary policy. The US-UK interest rate differential has been widening since October 2011, helping to keep GBP/USD fairly weak, thus, if movement in this spread slows then further losses in GBP/USD could be muted going forward.
The ECB’s Tough Talk
There were two developments in the Eurozone last week that could impact the value of the euro. The first was the Bundesbank’s annual meeting last week where President Jens Weidmann said that the ECB needs to start thinking about how to unwind its crisis measures like LTRO loans to Europe’s banking sector.
Added to this, the head of the Austrian Central Bank Nowotny said that further rate cuts from the ECB are not on the table right now. Weidmann was careful not to say that all emergency measures to help support the banks should be removed, however, he did say that the consequence of the LTRO auctions clearly raised the risks that the ECB now has to burden in the form of low-quality collateral that banks from the currency bloc can use to get hold of ECB cash.
So the ECB isn’t exactly hawkish, but it is unlikely to add any new stimulative measures to its policy mix any time soon. But what does this mean for the euro? We have noted in previous reports that the interest rate differential between the US and Germany (as benchmark for the currency bloc) has widened for the last five months. This has contributed to the bout of euro weakness we have seen since the late summer and the failure of EUR/USD to crack 1.35 in recent weeks. Thus, now that the ECB is talking tougher than it has in the past about inflation risks, the spread may not widen at such a fast clip.
This doesn’t mean that we will see a rebound in EUR/USD any time soon, even though the single currency had a storming finish to the European session on Friday. Instead, it suggests that further declines could be muted and we are back to range trading. As we start a new week, the range to note in EUR/USD is 1.3050-1.3250.
See also: COT Report Shows 2 Weakest Currencies
By Eric Viloria, senior technical strategist, FOREX.com
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